Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Chapter Inventories: Additional Issues QUESTIONS FOR REVIEW OF KEY TOPICS Question 9-1 GAAP generally require the use of historical cost to value assets, but a departure from cost is necessary when the utility of an asset is no longer as great as its cost The utility or benefits from inventory result from the ultimate sale of the goods This utility could be reduced below cost due to deterioration, obsolescence, or changes in price levels To avoid reporting inventory at an amount greater than the benefits it can provide, the lower-of-cost-or-market approach to valuing inventory was developed This approach results in the recognition of losses when the value of inventory declines below its cost, rather than in the period in which the goods are ultimately sold Question 9-2 The designated market value in the LCM rule is the middle number of replacement cost (RC), net realizable value (NRV) and net realizable value less a normal profit margin (NRV-NP) This is the amount compared with cost to determine LCM Question 9-3 The LCM determination can be made based on individual inventory items, on logical categories of inventory, or on the entire inventory Question 9-4 The preferred method is to record the loss from the write-down of inventory as a separate item in the income statement rather than including the write-down in cost of goods sold A less desirable alternative is to include the loss in cost of goods sold Question 9-5 The gross profit method estimates cost of goods sold, which is then subtracted from cost of goods available for sale to obtain an estimate of ending inventory The estimate of cost of goods sold is found by multiplying sales by the historical ratio of cost to selling prices The cost percentage is the reciprocal of the gross profit ratio Question 9-6 The key to obtaining accurate estimates when using the gross profit method is the reliability of the cost percentage If the cost percentage is too low, cost of goods sold will be understated and ending inventory overstated Cost percentages usually are based on relationships of past years, which aren’t necessarily representative of the current relationship Failure to consider theft or spoilage also could cause an overstatement of ending inventory Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 9-1 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 9-7 The retail inventory method first determines the amount of ending inventory at retail by subtracting sales for the period from goods available for sale at retail Ending inventory at retail is then converted to cost by multiplying it by the cost-to-retail percentage Question 9-8 The main difference between the gross profit method and the retail inventory method is in the determination of the cost percentage used to convert sales at selling prices to sales at cost The retail inventory method uses a cost percentage, called the cost-to-retail percentage, which is based on a current relationship between cost and selling price The gross profit method relies on past data to reflect the current cost percentage Question 9-9 Initial markup — Original amount of markup from cost to selling price Additional markup — Increase in selling price subsequent to initial markup Markup cancellation — Elimination of an additional markup Markdown — Reduction in selling price below the original selling price Markdown cancellation — Elimination of a markdown Question 9-10 When using the retail method to estimate average cost, the cost-to-retail percentage is determined by dividing total cost of goods available for sale by total goods available for sale at retail By including beginning inventory in the calculation of the cost-to-retail percentage, the percentage reflects the average cost/retail relationship for all inventory, not just the portion acquired in the current period Question 9-11 The lower-of-cost-or-market (LCM) retail variation combined with the average cost method is called the conventional retail method The LCM rule is incorporated into the retail inventory estimation procedure by excluding markdowns from the calculation of the cost-to-retail percentage Question 9-12 When applying LIFO, if inventory increases during the year, none of the beginning inventory is assumed sold Ending inventory includes the beginning inventory plus the current year’s layer To determine layers, we compare ending inventory at retail to beginning inventory at retail and assume that no more than one inventory layer is added if inventory increases Each layer carries its own cost-to-retail percentage that is used to convert each layer from retail to cost Question 9-13 Freight-in is added to purchases in the cost column Net markups are added in the retail column before the calculation of the cost-to-retail percentage Normal spoilage is deducted in the retail column after the calculation of the cost-to-retail percentage If sales are recorded net of employee discounts, the discounts are added to net sales before sales are deducted in the retail column © The McGraw-Hill Companies, Inc., 2007 9-2 Intermediate Accounting,4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 9-14 The dollar-value LIFO retail method eliminates the stable price assumption of regular retail LIFO In effect, it combines dollar-value LIFO (Chapter 8) with LIFO retail Before comparing beginning and ending inventory at retail prices, ending inventory is deflated to base year retail using the current year’s retail price index After identifying the layers in ending inventory with the years they were created, in addition to converting retail prices to cost using the cost-to-retail percentage, the dollar-value LIFO method requires that each layer first be converted from base year retail to layer year retail using the year’s retail price index Question 9-15 Changes in inventory methods, other a change to the LIFO method, are reported retrospectively This means reporting all previous periods’ financial statements as if the new inventory method had been used in all prior periods Question 9-16 When a company changes to the LIFO inventory method from any other method, it usually is impossible to calculate the income effect on prior years To so would require assumptions as to when specific LIFO inventory layers were created in years prior to the change As a result, a company changing to LIFO usually does not report the change retrospectively Instead, the LIFO method simply is used from that point on The base year inventory for all future LIFO determinations is the beginning inventory in the year the LIFO method is adopted Question 9-17 If a material inventory error is discovered in an accounting period subsequent to the period in which the error is made, any previous years’ financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction And, of course, any account balances that are incorrect as a result of the error are corrected by journal entry If retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to the beginning balance in the statement of shareholders’ equity In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary item, and earnings per share Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 9-3 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (concluded) Question 9-18 2004: 2005: Cost of goods sold Net income Ending retained earnings Net purchases Cost of goods sold Net income Ending retained earnings overstated understated understated no effect understated overstated correct Question 9-19 Purchase commitments are contracts that obligate the company to purchase a specified amount of merchandise or raw materials at specified prices on or before specified dates These agreements are entered into primarily to secure the acquisition of needed inventory and to protect against increases in purchase price Question 9-20 Purchases made pursuant to a purchase commitment are recorded at the lower of contract price or market price on the date the contract is executed A loss is recognized if the market price is less than the contract price For purchase commitments outstanding at year-end, a loss is recognized if the market price at year-end is less than the contract price © The McGraw-Hill Companies, Inc., 2007 9-4 Intermediate Accounting,4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com BRIEF EXERCISES Brief Exercise 9-1 NRV = $30 - = $26 NRV – NP = $26 – (30% x $30) = $17 RC = $18 The designated market is the middle value of NRV, NRV-NP, and RC, which is $18 Since this is lower than the cost of $20, the unit value is $18 Brief Exercise 9-2 (1) (2) Ceiling NRV (*) (3) Floor NRV-NP (**) Product RC $48 $64 $54 26 32 24 (4) (5) Cost Per Unit Inventory Value [Lower of (4) and (5)] $54 $50 $50 26 30 26 Designated Market Value [Middle value of (1), (2) & (3)] * Selling price less disposal costs ** NRV less normal profit margin Product (1,000 units) Product (1,000 units) Cost LCM value Cost $50,000 30,000 $80,000 LCM $50,000 26,000 $76,000 Before-tax income will be lower by $4,000, the amount of the required inventory write-down Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 9-5 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 9-3 Beginning inventory (from records) Plus: Net purchases (from records) Cost of goods available for sale Less: Cost of goods sold: Net sales Less: Estimated gross profit of 30% Estimated cost of goods sold Estimated cost of inventory destroyed $220,000 400,000 620,000 $600,000 (180,000) (420,000) $200,000 Brief Exercise 9-4 Beginning inventory (from records) Plus: Net purchases (from records) Cost of goods available for sale Less: Cost of goods sold: Net sales Less: Estimated gross profit Estimated cost of goods sold Estimated cost of inventory lost $150,000 450,000 600,000 $700,000 ( ? ) ( ? ) $ 75,000 Estimated cost of goods sold = $600,000 – 75,000 = $525,000* Estimated gross profit = $700,000 – 525,000* = $175,000 $175,000 ÷ $700,000 = 25% gross profit ratio © The McGraw-Hill Companies, Inc., 2007 9-6 Intermediate Accounting,4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 9-5 Cost $300,000 861,000 22,000 Beginning inventory Plus: Net purchases Freight-in Net markups Less: Net markdowns Goods available for sale 1,183,000 Retail $ 450,000 1,210,000 48,000 (18,000) 1,690,000 $1,183,000 Cost-to-retail percentage: = 70% $1,690,000 Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost (70% x $490,000) Estimated cost of goods sold Solutions Manual, Vol.1, Chapter (1,200,000) $ 490,000 (343,000) $ 840,000 © The McGraw-Hill Companies, Inc., 2007 9-7 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 9-6 Beginning inventory Plus: Net purchases Freight-in Net markups Less: Net markdowns Goods available for sale (excluding beg Inventory) Goods available for sale (including beg Inventory) Cost $300,000 861,000 22,000 _ 883,000 1,183,000 Retail $450,000 1,210,000 48,000 (18,000) 1,240,000 1,690,000 $883,000 Cost-to-retail percentage: = 71.21% $1,240,000 Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost: Retail Cost Beginning inventory $ 450,000 $ 300,000 Current period’s layer 40,000 x 71.21 % = 28,484 Total $ 490,000 $328,484 (328,484) Estimated cost of goods sold $854,516 © The McGraw-Hill Companies, Inc., 2007 9-8 (1,200,000) $ 490,000 Intermediate Accounting,4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 9-7 Cost $300,000 861,000 22,000 Beginning inventory Plus: Net purchases Freight-in Net markups Goods available for sale Retail $ 450,000 1,210,000 48,000 1,708,000 $1,183,000 Cost-to-retail percentage: = 69.26% $1,708,000 Less: Net markdowns Goods available for sale 1,183,000 Less: Net sales Estimated ending inventory at retail Estimated ending inventory at cost (69.26% x $490,000) (339,374) Estimated cost of goods sold $ 843,626 Solutions Manual, Vol.1, Chapter (18,000) 1,690,000 (1,200,000) $ 490,000 © The McGraw-Hill Companies, Inc., 2007 9-9 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 9-8 Cost $220,000 640,000 17,800 Beginning inventory Plus: Purchases Freight-in Plus: Net markups Retail $ 400,000 1,180,000 16,000 1,596,000 $877,800 Cost-to-retail percentage: = 55% $1,596,000 Less: Net markdowns Goods available for sale Less: Normal spoilage Net sales* _ 877,800 Estimated ending inventory at retail Estimated ending inventory at cost (55% x $272,000) (149,600) Estimated cost of goods sold $728,200 (6,000) 1,590,000 (3,000) (1,315,000) $272,000 *$1,300,000 + 15,000 (employee discounts) = $1,315,000 © The McGraw-Hill Companies, Inc., 2007 9-10 Intermediate Accounting,4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Problem 9-12 Requirement Analysis: 2004 Beginning inventory Plus: Net purchases Less: Ending inventory Cost of goods sold Revenues Less: Cost of goods sold Less: Other expenses Net income → ↑ U-6,000 O-6,000 U-6,000 U-3,000 O-9,000 U-18,000 U-6,000 Revenues Less: Cost of goods sold U-18,000 Less: Other expenses Net income O-18,000 U-6,000 Retained earnings O-6,000 Retained earnings U = Understated O = Overstated 2005 Beginning inventory Plus: Net purchases Less: Ending inventory Cost of goods sold O-12,000 Requirement Retained earnings Inventory Purchases 12,000 9,000 3,000 Requirement The financial statements that were incorrect as a result of both errors (effect of one error in 2004 and effect of three errors in 2005) would be retrospectively restated to report the correct inventory amounts, cost of goods sold, income, and retained earnings when those statements are reported again for comparative purposes in the 2006 annual report A “prior period adjustment” to retained earnings would be reported, and a disclosure note should describe the nature of the error and the impact of its correction on each year’s net income, income before extraordinary items, and earnings per share © The McGraw-Hill Companies, Inc., 2007 9-58 Intermediate Accounting,4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Problem 9-13 Requirement December 31, 2006 inventory, based on a physical count Add: Merchandise shipped f.o.b shipping point in 2006 Merchandise shipped f.o.b shipping point in 2006 Correct ending inventory Analysis: 2006 Beginning inventory Plus: Net purchases Less: Ending inventory Cost of goods sold Revenues Less: Cost of goods sold Less: Other expenses Net income Retained earnings $450,000 20,000 80,000 $550,000 U = Understated O = Overstated U-130,000 ($50,000 + 80,000) U-100,000 U -30,000 U -30,000 O -30,000 O -30,000 Requirement Retained earnings 30,000 Inventory 100,000 Accounts payable 130,000 Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 9-59 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Problem 9-14 Requirement a $10.50 If market price is equal to or greater than the contract price, the purchase is recorded at cost Purchases ($10.00 x 10,000 units) 100,000 Cash 100,000 b $9.50 If market price is less than the contract price, the purchase is recorded at the market price Purchases ($9.50 x 10,000 units) Loss on purchase commitment (difference) Cash 95,000 5,000 100,000 Requirement a $12.50 No entry is required Market price is greater than contract price b $10.30 If market price at year-end is less than contract price for outstanding purchase commitments, a loss is recorded for the difference December 31, 2006 Estimated loss on purchase commitment [($11.00 x 20,000 units) - ($10.30 x 20,000 units)] Estimated liability on purchase commitment © The McGraw-Hill Companies, Inc., 2007 9-60 14,000 14,000 Intermediate Accounting,4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Problem 9-14 (concluded) Requirement a $11.50 If market price on purchase date has not declined from year-end price, the purchase is recorded at the year-end market price Purchases ($10.30 x 20,000 units) 206,000 Estimated liability on purchase commitment 14,000 Cash ($11.00 x 20,000 units) 220,000 b $10.00 If market price on purchase date declines from year-end price, the purchase is recorded at market price Purchases ($10.00 x 20,000 units) 200,000 Loss on purchase commitment ($220,000 - 200,000 -14,000)* 6,000 Estimated liability on purchase commitment 14,000 Cash ($11.00 x 20,000 units) 220,000 * or, ($10.30 - $10.00) x 20,000 units = $6,000 Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 9-61 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com CASES Judgment Case 9-1 Hudson should account for the warehousing costs related to its wholesale inventories as part of inventory All reasonable and necessary costs of preparing inventory for sale should be recorded as inventory cost This approach results in proper matching of the warehousing costs with revenue when the wholesale inventories are sold a The lower-of-cost-or-market method produces a more realistic estimate of future cash flows to be realized from assets, which is consistent with the principle of conservatism, and recognizes (matches) the anticipated loss in the income statement in the period in which the price decline occurs b Hudson’s wholesale inventories should be reported in the balance sheet at replacement cost According to the lower-of-cost-or-market method, replacement cost is defined as market However, market cannot exceed net realizable value and cannot be less than net realizable value less the normal profit margin In this instance, replacement cost is below original cost, below net realizable value, and above net realizable value less the normal profit margin Therefore, Hudson’s wholesale inventories should be reported at replacement cost Hudson’s freight-in costs should be included only in the cost amounts to determine the cost-to-retail percentage Hudson’s net markups should be included only in the retail amounts to determine the cost-to-retail-percentage Hudson’s net markdowns should not be deducted from the retail amounts to determine the cost-toretail percentage By not deducting net markdowns from the retail amounts to determine the cost-to-retail percentage, Hudson produces a lower cost-to-retail percentage than would result if net markdowns were deducted By applying this lower percentage to ending inventory at retail, the inventory is reported at an amount below cost, which approximates lower of average cost or market © The McGraw-Hill Companies, Inc., 2007 9-62 Intermediate Accounting,4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Communication Case 9-2 Arguments for the LCM approach versus historical cost should focus on the loss of utility concept A departure from cost is warranted when the utility of an asset (its probable future economic benefits) is no longer as great as its cost The utility or benefits from inventory result from the ultimate sale of the goods So, deterioration, obsolescence, changes in price levels, or any situation that might compromise the inventory’s salability impairs utility To avoid reporting inventory at an amount greater than the benefits it can provide, the lower-of-cost-or-market (LCM) approach to valuing inventory was developed Reporting inventories at LCM causes losses to be recognized when the value of inventory declines below its cost, rather than in the period in which the goods ultimately are sold A difference between LCM and a market value approach is that a market value approach would recognize income as market value increases above cost This results in recognizing income before the inventory is sold Arguments for the LCM approach should focus on the realization principle That is, in most situations, until inventory is sold, there exists significant uncertainty about the ultimate cash to be collected It is important that each student actively participate in the process of arriving at a solution Domination by one or two individuals should be discouraged Students should be encouraged to contribute to the group discussion by (a) offering information on relevant issues, and (b) clarifying or modifying ideas already expressed, or (c) suggesting alternative direction Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 9-63 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Integrating Case 9-3 Requirement York Co Schedule of Cost of Goods Sold For the Year Ended December 31, 2006 Beginning inventory Add: Purchases Less: Purchase discounts Add: Freight-in Goods available for sale Less: Ending inventory Cost of goods sold $ 65,600 368,900 (18,000) 5,000 421,500 (176,000) (1) $245,500 York Co Supporting Schedule of Ending Inventory December 31, 2006 Inventory at cost (LIFO): Units Beginning inventory, January 1, 8,000 Purchases, quarter ended March 31 12,000 Purchases, quarter ended June 30 2,000 22,000 Cost per unit $8.20 8.25 7.90 Total cost $ 65,600 99,000 15,800 $180,400 Inventory at market: 22,000 units @ $8 = $176,000 (1) Requirement Inventory should be valued at the lower of cost or market Market means current replacement cost, except that: (1) Market should not exceed the net realizable value; and (2) Market should not be less than net realizable value reduced by an allowance for a normal profit margin In this situation, because replacement cost ($8 per unit) is less than net realizable value, but greater than net realizable value reduced by a normal profit margin, replacement cost is used as © The McGraw-Hill Companies, Inc., 2007 9-64 Intermediate Accounting,4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com market Because inventory valued at market ($176,000) is lower than inventory valued at cost ($180,400), inventory should be reported in the financial statements at market Judgment Case 9-4 a The advantages of using the dollar-value LIFO method are to reduce the cost of accounting for inventory and to minimize the probability of liquidation of LIFO inventory layers b The application of dollar-value LIFO is based on dollars of inventory, an inventory cost index for each year, and broad inventory pools The inventory layers are identified with the inventory cost index for the year in which the layer was added In contrast, traditional LIFO is applied to individual units at their cost a Huddell’s net markups should be included only in the retail amounts (denominator) to determine the cost-to-retail percentage Huddell’s net markdowns should be ignored in the calculation of the cost-to-retail percentage b By not deducting net markdowns from the retail amounts to determine the cost-to-retail percentage, Huddell produces a lower cost-to-retail percentage than would result if net markdowns were deducted Applying this lower percentage to ending inventory at retail, the inventory is reported at an amount below cost This amount is intended to approximate the lower of average cost or market Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 9-65 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Communication Case 9-5 Suggested Grading Concepts and Grading Scheme: Content (70%) 30 Describes the method _ Determining ending inventory at retail Multiply ending inventory at retail by the cost percentage _ Markups and markdowns 10 Discusses the conditions that may distort results _ Possible inaccurate cost percentage Does not explicitly consider theft, breakage, etc 30 Describes the advantages of using the method when compared to other methods _ Avoids physical inventory count _ Acceptable for financial reporting and income taxes _ Can explicitly incorporate cost flow methods, taxes, and LCM 70 points Writing (30%) Terminology and tone appropriate to the audience of a company president 12 Organization permits ease of understanding _ Introduction that states purpose _ Paragraphs that separate main points 12 English _ Sentences grammatically clear and well organized, concise _ Word selection _ Spelling _ Grammar and punctuation 30 points © The McGraw-Hill Companies, Inc., 2007 9-66 Intermediate Accounting,4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Analysis Case 9-6 For changes not involving LIFO or changes from the LIFO method to another, the event is accounted for as a normal change in accounting principle In general, we report voluntary changes in accounting principles retrospectively This means revising all previous periods’ financial statements as if the new method were used in those periods In other words, for each year in the comparative statements reported, we revise the balance of each account affected More specifically, we make those statements appear as if the newly adopted accounting method had been applied all along Also, if retained earnings is one of the accounts whose balance requires adjustment (and it usually is), we make an adjustment to the beginning balance of retained earnings for the earliest period reported in the comparative statements of shareholders’ equity (or statements of retained earnings if they’re presented instead) Then we create a journal entry to adjust all account balances affected as of the date of the change The advantage of retrospective application is to enhance comparability of the statements from year to year The recast statements appear as if the newly adopted accounting method had been applied in all previous years Consistency and comparability suggest that accounting choices once made should be consistently followed from year to year So, any change requires that the new method be justified as clearly more appropriate In the first set of financial statements after the change, a disclosure note is needed to provide that justification The footnote also should point out that comparative information has been revised and report any per share amounts affected for the current period and all prior periods presented When a company changes to the LIFO inventory method from any other method, it usually is impracticable to calculate the cumulative effect of the change Revising balances in prior years would require knowing what those balances should be LIFO inventory, though, consists of “layers” added in prior years at costs existing in those years If another method has been used, the company probably hasn’t kept a record of those costs Accordingly, accounting records of prior years usually are inadequate to report the change retrospectively Because of this difficulty, a company changing to LIFO usually does not report the change retrospectively Instead, the base year inventory for all future LIFO calculations is the beginning inventory in the year the LIFO method is adopted Then, the LIFO method is applied prospectively from that point on The disclosure note must include an explanation as to why retrospective application was impracticable Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 9-67 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Real World Case 9-7 Requirement We report most voluntary changes in accounting principles retrospectively This means recasting all previous periods’ financial statements as if the new method were used in those periods For each year in the comparative statements reported, we revise the balance of each account affected so that those statements appear as if the newly adopted accounting method had been applied all along Then we create a journal entry to adjust all account balances affected as of the date of the change GAAP require retrospective application to enhance comparability of the statements from year to year The revised statements are made to appear as if the newly adopted accounting method (average cost method in this case) had been applied in all previous years Requirement The note reports that the switch to the average cost method caused an increase in earnings per share of 17 cents for the first nine months of 2000 In order for the average method to result in higher earnings (lower cost of goods sold) than LIFO (assuming the quantity of inventory did not change), the cost of inventory must have increased during the year Real World Case 9-8 Requirement a During the fourth quarter of its fiscal year ended June 30, 2003, the Company changed its method of accounting for inventories from LIFO to the average cost method for all inventories not previously accounted for on the average cost method b The change in method increased retained earnings as of July 1, 2000 by $451,000 c The effect of the change was to increase net income for fiscal 2002 by $6,000 © The McGraw-Hill Companies, Inc., 2007 9-68 Intermediate Accounting,4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Communication Case 9-9 Requirement Change in Inventory Method During 2006, the Company changed the method of valuing its inventories from the first-in, first-out (FIFO) method, to the last-in, first-out (LIFO) method, determined by the retail method To estimate the effects of changing retail prices on inventories, the Company utilizes internally developed price indexes The impact of the change was to decrease 2006 net income by $13.2 million and to decrease earnings per share by $0.13 Management has determined that retrospective application of the change is impracticable because the cumulative effect of the change on prior years was not determinable The Company believes that the change to the LIFO method provides a more consistent matching of merchandise costs with sales revenue and also provides a more comparable basis of accounting with competitors Note: Because cost of goods sold would have been $22 million lower if the change had not been made, income before tax would have been $22 million higher, and net income would have been $13.2 million higher ($22 million multiplied by 60% [1 - 40]) Requirement It usually is impracticable to calculate the cumulative effect of a change to LIFO To so would require assumptions as to when specific LIFO inventory layers were created in years prior to the change Accounting records usually are inadequate for a company to create the appropriate LIFO inventory layers That’s why a change to LIFO usually can’t be applied retrospectively Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 9-69 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Judgment Case 9-10 Despite the self-correcting feature of certain inventory errors, the errors cause the financial statements of the year of the error as well as the financial statements in the subsequent year to be incorrect For example, an overstatement of ending inventory at the end of 2005 will correct itself in 2006 and retained earnings at the end of 2006 will be correct However, cost of goods sold and net income will be incorrect in both years In addition, inventory and retained earnings on the 2005 balance sheet will be incorrect If a material inventory error is discovered in an accounting period subsequent to the period in which the error is made, previous years’ financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction And, of course, any account balances that are incorrect as a result of the error are corrected by journal entry If retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to the beginning balance of retained earnings in the statement of shareholders’ equity In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary item, and earnings per share © The McGraw-Hill Companies, Inc., 2007 9-70 Intermediate Accounting,4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Ethics Case 9-11 Requirement Bonuses will be negatively affected because if the error is corrected, a lower ending inventory results in higher cost of goods sold and lower income The effect of the error would be an overstatement of pre-tax income by $665,000 ($3,265,000 2,600,000) Requirement It will be reported as a prior period adjustment to the beginning retained earnings balance for the year beginning July 1, 2006 Financial statements for the year ending June 30, 2006, will be retrospectively restated to reflect the correct inventory amount, cost of goods sold, net income, and retained earnings Requirement Ethical Dilemma: Should John recognize his obligation to disclose the inventory error to Danville shareholders, the local bank, auditors, and taxing authorities or remain quiet, enabling him and other company employees to receive originally computed year-end bonuses? Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 9-71 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Analysis Case 9-12 ARB 43 requires that purchase commitments be evaluated in the same way as inventory on hand for the purpose of determining any lower-of-cost-or-market (LCM) adjustment Purchases are recorded at market price when market price is lower than the agreed upon contract price, and a loss is recognized for the difference between market price and contract price Also, losses must be recognized for any purchase commitments outstanding at the end of a reporting period when market price is less than contract price In this case, the contract price of $.80 per gallon is compared to the market price at December 31 If market is less than $.80, an estimated loss is recognized for the difference multiplied by the million gallon commitment An estimated liability is recorded for the loss If market price is greater than $.80, then no year-end adjustment is necessary As the heating oil is purchased in 2007, if an estimated loss is recorded at yearend, the purchases are recorded at the lower of market price and year-end price If no loss is recorded at year-end, the purchases are recorded at the lower of market price and contract price © The McGraw-Hill Companies, Inc., 2007 9-72 Intermediate Accounting,4/e ... will be lower by $4,000, the amount of the required inventory write-down Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 9-5 Find more slides, ebooks, solution manual and... extraordinary item, and earnings per share Solutions Manual, Vol.1, Chapter © The McGraw-Hill Companies, Inc., 2007 9-3 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com... than the contract price © The McGraw-Hill Companies, Inc., 2007 9-4 Intermediate Accounting, 4/e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com BRIEF EXERCISES Brief